Enterprise value (EV) is a very important concept in corporate valuation and upon which many M&A deals are based.

In simple terms, Enterprise Value is the outlay or cost of buying the entire (100%) company by a potential investor. Thus, apart from the equity shareholders, the other types of shareholding i.e. preference and minority shareholders as well as the outsiders i.e. debt, both short term and long term, will have to be settled.

The buyer would have to acquire the equity share capital, the preference shares, settle the debt, buy the shareholding of the minority interest and takeover the cash and cash equivalents.

Accordingly, the formula is as follows.

Given its wholistic coverage as against market capitalization, enterprise value is an effective tool to compute the value of a company. The enterprise value may then be divided by the number of outstanding shares to decide the target price per share.

Enterprise Value Formula

EV= Market Capitalization+ Preferred Stock+ Outstanding Debt+ Minority Interest- Cash and Cash equivalents

Alternative Formula

EV= Market capitalization+ Market value of debt- Cash and cash equivalents

It must be remembered that over and above the value of the company, there would be a takeover premium as well. While debt increases the acquisition price, cash goes to decrease the target price for the acquirer.

Rationale Behind Adopting Enterprise Value?

1.Simplicity

The balance sheet of a company reflects both assets and liabilities.

Similarly, the sources and uses of funds reflect a company’s stakeholders which include owners’ capital as well as claims. It is quite a tedious process to compute the current market value of each and every asset, which is recorded at historical cost and depreciation charges.

Thus, it is worthwhile to consider the current value of the funding of these assets i.e. market capitalization and market value of debt. Enterprise value reflects the entire value of a company while market capitalization reflects the price.

2. Multiples as Comparable

Enterprise value, in turn, has several multiples to evaluate corporate performance, based on the inherent characteristics of an industry or sector.

This way the acquirer can compare the potential returns from multiple enterprises across industries before deciding upon acquiring a controlling stake.

Consider the EV/Sales and EV/EBITDA Values of the Following Industries

 

Industry multiples in India as of June 30, 2018: Duff & Phelps report

 

Companies from S&P BSE 500 Index (mean value)EV/SalesEV/EBITDA
Consumer discretionary: Apparel2.5x22.2x
Consumer Discretionary: Auto Parts2.3x15.7x
Consumer Discretionart: Household Appliances2.9x29.2x
Electric and Gas Utilities3.1x9.1x
Energy1.0x6.0x
Household and Personal Products5.2x25.8x
Industrial Machinery2.7x20.9x
Internet Software and Services2.6x14.7x
Materials: Chemicals3.0x17.2x
Materials: Construction2.1x12.4x
Materials: Metals and Mining1.7x9.0x
Pharmaceuticals and Biotechnology3.9x16.7x
Real Estate5.1x17.4x

Enterprise Value is often used to compute multiples like EV/EBITDA, EV/EBIT, EV/FCF or EV/Sales for comparative analysis in valuation models like trading comps.

Consider an example.

Assume someone said that an earning was generated of  Rs. 1 lakh from FDs and Rs. 1 lakh from shares as well. This is not a very meaningful comparison, being in absolute terms. It may seem that both are yielding the same returns just by considering Rs.1 lakh return.

Also, you are aware that the risk profile is different in both the instruments. While FDs are relatively low risk, equity is high risk. Now, consider if someone further said that the earning rate was 7% on FDs and 15% on equities based on the amount invested.

This is a more meaningful comparison as it is a % measure in relative terms. One can then conclude that equities perform better than FDs. Similarly, an EV multiple can be used to compare companies across industries, while Enterprise Value can be used within the same industry group.

The drawback of other formulae like P/E ratio is that they exclude the impact of cash and debt. Enterprise Value incorporates the cash and debt angles as well.

It may often happen that 2 companies in the same industry that are considered peers, may have the same market capitalization but different enterprise values. This may be due to one having a higher degree of leverage or higher cash in its books.

Companies prefer buyout of enterprises that have less debt in their books. However, other factors like business model, revenue streams, profitability and asset base also play a crucial role in determining the acquisition of the target.

Let’s consider a hypothetical example of two companies X & Y that operate in the same industry, have similar operations and sizing and are considered as comparable peers.

(In Crores)
Scenario 1Market capitalizationDebtCashEnterprise Value
Company X408543
Company Y402339
Scenario 2Market capitalizationDebtCashEnterprise Value
Company X408048
Company Y402042
Scenario 3Market capitalizationDebtCashEnterprise Value
Company X400535
Company Y400337

As one can see from the above table, the EV values differ in various scenarios, irrespective of the same market capitalization. It must be noted that in reality, it may not be possible to have a company with zero cash or zero debt.

Mainstay of Merger & Acquisition

Enterprise Value is very important in Mergers and Acquisition, especially where there is an acquisition of controlling interest or ownership aspects.

Further, since changing capital structure i.e. different leverage levels or cash balance would not impact the enterprise value, it is useful in comparison with peers that have a different capital structure.

In financial modeling like Discounted Cash Flow models (DCF), often the free cash flow to the firm(FCFF) is multiplied by the net present value (NPV) to arrive at the enterprise value(EV), assuming cash flow from taking over 100% of the business enterprise.

In this connection, there is a theorem by Modigliani and Miller called the Capital Structure Theory, which assumes a no tax scenario. The theory suggests that the valuation of a firm is not dependent upon its capital structure i.e. whether a firm is leveraged or unleveraged, has no impact on its market value.

The market value is influenced by the earning potential and the risk profile of its assets.

Components of Enterprise Value

Now that we know the formula of enterprise value, as well as the advantages of enterprise value over other valuation metrics, lets look at each of the components that make up enterprise value

1. Market Capitalization

The value of the equity held by ordinary shareholders is computed by multiplying the fully diluted outstanding shares with the prevailing market price.

Fully diluted shares include share options, share warrants, convertible securities as well as ordinary equity shares. A potential acquirer would have to compensate the equity shareholders for foregoing their ownership interest.

2. Debt

Debt includes outsiders’ liabilities i.e. short term as well as long term.

These generally carry an interest charge and may be liabilities of financial institutions by way of lending or other creditors like suppliers, vendors etc.

It is ideal to consider the market value of debt. However, if not available, the book value may be considered. Often, this component is computed by investment bankers as net debt.

In other words, a potential acquirer would subtract the cash reserves acquired as a consequence of corporate takeover from the assumed debt by settling a portion of the debt.

3. Preferred Shares

These are hybrid instruments with features of both equity as well as debt.

Their features are more akin to debt as they are paid a fixed dividend and have preferential treatment in settlement of dues over the ordinary shareholders as per the Companies Act.

For example, in case of liquidation proceedings, the preference shareholders would have priority over ordinary shareholders in asset claim or earnings claim. In an acquisition deal, the potential acquirer would treat this item as a debt item to be repaid.

4. Non-Controlling Stake

These are the shareholders who own less than 50% i.e. non-controlling stake, in a company. Since the acquirer intends to buy 100% of the business enterprise, these shareholders need to be settled monetarily.

Thus, the complete value of the subsidiary is included in the EV computation by adding the minority interest component.

Limitations of Enterprise Value

While Enterprise Value is useful in valuation for deals, there are some limitations.

1. Enterprise Value does not consider the interest cost of servicing debt and assumes that the cash taken over is immediately channelized towards settling debt.

2. Since market capitalization is an important component of enterprise value, it is of limited utility in case of unlisted company where the shares are quoted at face value or in case of a public listed company with limited float, where the share price can be altered to artificially show a higher value.

In such cases, alternate financial metrics like debt levels, cash flow, asset replacement value etc need to be considered.

Disclaimer: The views expressed in this post are that of the author and not those of Groww